1. Field of the Invention
The invention concerns techniques for allocating a resource among a number of potential uses for the resource such that a satisfactory tradeoff between a risk and a return on the resource is obtained. More particularly, the invention concerns improved techniques for determining the risk-return tradeoff for particular uses, techniques for determining the contribution of uncertainty to the value of the resource, techniques for specifying risks, and techniques for quantifying the effects and contribution of diversification of risks on the risk-return tradeoff and valuation for a given allocation of the resource among the uses.
2. Description of Related Art
People are constantly allocating resources among a number of potential uses. At one end of the spectrum of resource allocation is the gardener who is figuring out how to spend his or her two hours of gardening time this weekend; at the other end is the money manager who is figuring out how to allocate the money that has been entrusted to him or her among a number of classes of assets. An important element in resource allocation decisions is the tradeoff between return and risk. Generally, the higher the return the greater the risk, but the ratio between return and risk is different for each of the potential uses. Moreover, the form taken by the risk may be different for each of the potential uses. When this is the case, risk may be reduced by diversifying the resource allocation among the uses.
Resource allocation thus typically involves three steps:                1. Selecting a set of uses with different kinds of risks;        2. determining for each of the uses the risk/return tradeoff; and        3. allocating the resource among the uses so as to maximize the return while minimizing the overall risk.        
As is evident from proverbs like “Don't put all of your eggs in one basket” and “Don't count your chickens before they're hatched”, people have long been using the kind of analysis summarized in the above three steps to decide how to allocate resources. What is relatively new is the use of mathematical models in analyzing the risk/return tradeoff. One of the earliest models for analyzing risk/return is net present value; in the last ten years, people have begun using the real option model; both of these models are described in Timothy A. Luehrman, “Investment Opportunities as Real Options: Getting Started on the Numbers”, in: Harvard Business Review, July-August 1998, pp. 3-15. The seminal work on modeling portfolio selection is that of Harry M. Markowitz, described in Harry M. Markowitz, Efficient Diversification of Investments, second edition, Blackwell Pub, 1991.
The advantage of the real option model is that it takes better account of uncertainty. Both the NPV model and Markowitz's portfolio modeling techniques treat return volatility as a one-dimensional risk. However, because things are uncertain, the risk and return for an action to be taken at a future time is constantly changing. This fact in turn gives value to the right to take or refrain from taking the action at a future time. Such rights are termed options. Options have long been bought and sold in the financial markets. The reason options have value is that they reduce risk: the closer one comes to the future time, the more is known about the action's potential risks and returns. Thus, in the real option model, the potential value of a resource allocation is not simply what the allocation itself brings, but additionally, the value of being able to undertake future courses of action based on the present resource allocation. For example, when a company purchases a patent license in order to enter a new line of business, the value of the license is not just what the license could be sold to a third party for, but the value to the company of the option of being able to enter the new line of business. Even if the company never enters the new line of business, the option is valuable because the option gives the company choices it otherwise would not have had. For further discussions of real options and their uses, see Keith J. Leslie and Max P. Michaels, “The real power of real options”, in: The McKinsey Quarterly, 1997, No. 3, pp. 4-22, and Thomas E. Copland and Philip T. Keenan, “Making real options real”, The McKinsey Quarterly, 1998, No. 3, pp. 128-141.
In spite of the progress in applying mathematics to the problem of allocating a resource among a number of different uses, difficulties remain. First, the real option model has heretofore been used only to analyze individual resource allocations, and has not been used in portfolio selection. Second, there has been no good way of quantifying the effects of diversification on the overall risk.
Experience with the resource allocation system of U.S. Ser. No. 10/018,696 has demonstrated the usefulness of the system, but has also shown that it is unnecessarily limited. It is an object of the invention disclosed herein to overcome the limitations of U.S. Ser. No. 10/018,696 and thereby to provide an improved resource allocation system.